[The following guest post is contributed by Kemi Gupta, who is a 5th year B.A., LL.B (Hons.) student at NALSAR University of Law]
In a matter of only a few years, India's alternative investment industry has grown to Rs. 20,700 crore in size, and is yet claimed to be in its early stages. Alternative investment funds ("AIFs") constitute any privately pooled investment vehicles, established or incorporated in India, in the form of a trust, company, limited liability partnership or a body corporate, not covered under any other regulations prescribed by the Securities and Exchange Board of India (“SEBI”) or other sectoral regulations. They are divided into three categories depending on the impact they have on the economy.
AIFs have gained tremendous significance in the Indian market. The total number of registered AIFs has increased from 73 in August 2013 to a total of 235 as per the data available for June 2016. Since its introduction in 2012, the growth rate in terms of funds raised and investments made is unparalleled. The cumulative funds raised via AIFs in 2016 show an increase of about 38 times their value three years ago whereas an increase in the total investments made reflects a 45-fold increase.
The focus of this post is limited to understanding the current law on foreign investments in Category III AIFs. Unlike Category I funds which are known to have a positive spillover effect on the economy, Category III AIFs have the potential of giving rise to a negative externality. These funds undertake leverage to a great extent and trade with a view to making short-term returns. Hedge funds are one of the major examples of Category III funds which employ diverse or complex trading strategies to invest and trade in securities which carry diverse risks. Considering the peculiar nature of investment, Category III AIFs are additionally required to comply with norms pertaining to risk management, compliance, redemption and leverage.
Earlier, pooling of capital was allowed only for Indian investors, and investment was done according to a pre-determined policy. Foreign investment was allowed only in venture capital funds (“VCFs”), if structured as a trust, and subject to a case-by-case approval granted by the Foreign Investment Promotion Board (“FIPB”). This was further subject to the applicable regulations on foreign direct investment (“FDI”): for instance, venture capital funds could not invest directly in the e-commerce sector as it was in violation of the FDI regulations.
By way of a Notification issued by the Reserve Bank of India, foreign investments in AIFs have now been allowed under the automatic route. Persons resident outside India, including a registered foreign portfolio investor (“RFPI”) and a non-resident Indian (“NRI”), have been allowed to invest in units of AIFs. Furthermore, the extent of foreign investment in the corpus of the AIF will no longer be a factor in determining whether downstream investment of the AIF will constitute foreign investment or not.
Therefore, with this new change, the implication would be that a pooled investment vehicle in India could have majority or even almost the entire investment from offshore investors and still buy into businesses where foreign ownership is restricted. Funds are considered as 'domestic' in nature so long as their sponsors and managers are Indian. In other words, what matters is that sponsors and managers ought to be Indian “owned and controlled”, but the investment in the AIF itself could be made by foreign investors. This is because in such a fund structure, the control is said to be with the sponsors and managers, rather than investors. AIFs so sponsored or managed are free to invest in all sectors, without being bound by any of the sectoral restrictions and caps imposed under the FDI rules. For instance, downstream investments by AIFs in sectors such as e-commerce, insurance, retail, defence etc. which were previously restricted, can now be bypassed.
After the announcement, the total amount of funds raised and investments made by AIFs have shown a tremendous growth rate collectively. However, individually, Category III reflects a growth rate only 14.58 per cent as opposed to a 115 per cent growth in Category II and 18.49 per cent in Category I. Categories I and II have displayed better progress in the 9 month period since the allowance of foreign investments in AIFs as compared to the investments made by Category III AIFs in the same period. The introduction of foreign investments is a relatively new affair for AIFs, and a proper analysis of growth is only possible with the passage of time.
There is one specific restriction imposed with regard to Category III under the notification. A Category III AIF with foreign investment is allowed to make portfolio investment in only those securities or instruments in which an RFPI is permitted to invest. Therefore, in order to fully understand the investment opportunities available to Category III foreign investments, it would be necessary to look at the investment options available to an RFPI.
Regulation 21 of the SEBI (Foreign Portfolio Investors) Regulations, 2014 (“FPI Regulations”) provides for the type of instruments in which RFPIs can invest. Some of these include securities in the primary and secondary markets including shares, debentures and warrants of companies, listed or to be listed on a recognized stock exchange in India; units of schemes floated by domestic mutual funds and schemes floated by collective investment schemes, derivatives, treasury bills and dated government securities, commercial papers issued by an Indian company, rupee denominated credit enhanced bonds; security receipts issued by asset reconstruction companies etc. Investment in unlisted debt securities is permitted only in the infrastructure sector.
Keeping in mind the aim of developing the corporate bond market, the Reserve Bank of India in a potential move to encourage further foreign investment into the debt markets, released a draft circular on 16 May 2016 which proposes to expand the basket of permissible instruments for RFPI to include unlisted debt securities as well.. As per the proposal, RFPIs shall be permitted to invest in the primary issuances by public companies of unlisted non-convertible debentures, thereby expanding the scope of investment opportunities available to Category III AIFs with foreign investments.
As far as the tax liability is concerned, while Categories I and II have been extended a pass through status, Category III is yet to be extended the same privilege. Under the pass-through system, income of an investment fund is exempted from tax and such income is chargeable to income-tax in the hands of the unit-holder in the same manner as if the investment was directly made by the unit holder. Despite the recommendations made by the Narayana Murthy Committee, pass through status has not been conferred on Category III AIFs. It is subject to tax as a representative assessee instead of being taxed at the investor level. This has impaired the expected development of the domestic hedge fund industry and might run counter to the Reserve Bank of India’s aim for which it permitted foreign investments in Category III AIFs.
Overall, despite the risk-intensive nature of Category III AIFs, extending the availability of foreign investment benefits in this category is surely a welcome step. However, in order to enhance the availability of this investment mechanism, suitable reforms need to be made to tax laws.
- Kemi Gupta
 The SEBI (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”) were notified on May 21, 2012.
 Net figure of the total 'Investment made' as at the end of 30th June, 2016, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
 Regulation 2(1)(b) of the AIF Regulations.
 Namely Category I, Category II and Category III. The investment conditions and restrictions for each for these categories of funds are prescribed under the AIF Regulations.
 List of Registered Alternative Investment Funds as on June 30, 2016, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1469684217867.pdf.
 The cumulative funds raised via AIFs stood at Rs. 26,003.48 crore as on 30 June 2016 from a total of Rs. 687.97 crore as on June 2013: Cumulative Net Figures of 'Commitments raised',' Funds raised' and 'Investments made' as compiled by SEBI from time-to-time, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
 An increase from Rs. 451.71 crores to 20667.2 crores from June, 2013 to June, 2016, Available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1470648818515.html
 Regulation 3(4)(a) of the AIF Regulations.
 Regulation 3(4)(c) of the AIF Regulations.
 Regulation 18 of the AIF Regulations.
 Amendment to the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India), 2015 and Foreign Exchange Management (Permissible Capital Account Transactions) (Fourth Amendment) Regulations, 2015, which have been notified vide , vide G.S.R. No.859 (E) dated November 16, 2015 and , vide G.S.R. No.858 (E) dated November 16, 2015 respectively.
 The total amount of funds raised has increased from Rs. 17,241.07 crore as on 31 December 2015 to Rs. 26,003.48 crore as on 30 June 2016 and the increase in investments made for the same period has shown an increase from Rs. 14,031.39 crore to Rs. 20,667.2 crore. Cumulative Net Figures of 'Commitments raised',' Funds raised' and 'Investments made' as compiled by SEBI from time-to-time, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
 An increase in the total amount of funds raised from Rs. 4,375.94 crore in December 2015 to Rs. 4,854.48 crore in June 2016. The growth rate is calculated for a period of 9 months. Raw data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
 An increase in the total amount of funds raised from Rs. 8,988 crore in December 2015 to 16,734.99 crore in June 2016. The growth rate is calculated for a period of 9 months. Raw data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
 An increase from Rs. 3,876.52 crore to Rs. 4,414.01 crore in the same period. The growth rate is calculated for a period of 9 months. Raw data available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1477629704398.html.
 'RBI invites comments on allowing FPIs in Unlisted Debt Securities and Securitized Debt Instruments', Press Release: 2015-2016/2673, Available at: https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=36990 (May 16, 2016)
 However, the AIFs are provided only a partial pass-through status. The losses suffered by AIFs are not allowed to be passed on to the investors.
 Report submitted by Alternative Investment Policy Advisory Committee, available at: http://www.sebi.gov.in/cms/sebi_data/attachdocs/1453278327759.pdf.